The wider state of the fixed income market in 2024 has been discussed at large, with consensus that careful management of the trends are needed to align portfolios with long-term profitability.
As part of this, Nelson A. Pereira, Investment Director, Insurance, Mercer moderated a panel discussion with Christopher Brown, Head of Securitised Products, T. Rowe Price, and Michael Hackmann, Vice President of Investments, Shelter Insurance, as well as representatives from Liberty Mutual Insurance and Converge US, when speaking at the Insurance Investor Live | North America event in December last year in New York, which is now featured in the Insurance Asset Management North America 2024 report.
In it, the group looked at some of the biggest issues that will affect the market over the course of 2024 and beyond, including investing in emerging markets, the state of commercial real estate, and artificial intelligence. As well as they looked at fixed income in its various facets.
You can read Hackmann and Brown’s views on the topic from the panel discussion below.
Chris Brown: Yes, and the nice thing about securitised is that it is a dozen asset classes within one larger asset class, so there are a lot of different flavours.
[In the context of Mortgage-Backed Securities (MBS)], they have had a tough time over the past couple of years and have gotten beaten up. Whether you are looking at it from a yield or Option-Adjusted Spread (OAS) perspective, the great thing about agency MBS is that there are 20 different ways to look at the valuation, but any way that you look at it they are cheap to corporate credit right now.
We mentioned the divergence between interest rate volatility and credit volatility. Interest rate volatility is elevated relative to credit volatility. This is what has hurt agency MBS, and if you expect that relationship to converge, and the Fed is at the end of its hiking cycle, we can debate when cuts are going to come and how much they are going to be. But, if they are at the end of their hiking cycle, then also by definition interest rate volatility should decline, which is great for agency MBS. It is an attractive asset class that is liquid, probably the second most liquid market in the fixed income market.
"Yields at the front end of the curve are quite elevated right now,
so you are getting a lot of yield with minimal price volatility."
If you want to go to the credit area – and by credit I mean asset-backed securities (ABS), non-agency MBS, collateralised loan obligations (CLO), and commercial mortgage-backed securities (CMBS) – there are a few pockets of opportunity as well. You do want to be careful because, again, we are closer to the end of the credit cycle, but there are some nice pockets. Broadly, securitised credit has lagged behind the rally that we have seen over the past couple of months, and so it is sticking out from a relative value standpoint.
The areas that I would point to in the asset-backed security market include equipment ABS, which is looking quite cheap. We are active in the whole business asset-backed security market, and that is looking fairly cheap. These tend to be shorter securities with shorter duration, so you don’t get the price volatility that you get with longer-duration assets. We know that yields at the front end of the curve are quite elevated right now, so you are getting a lot of yield with minimal price volatility.
Maybe somewhat controversially given the negative news around it, in the CMBS space we like AAA conduit, CMBS. These are top of the capital structure and have 30% credit enhancement. If I look across the spectrum of securitised assets and look at what has lagged the most then CMBS as an asset class is at the top of the list, but I feel that this is one area where you can stay high quality, get a security that has a spread of about 150 over the treasury curve, which is historically attractive, and has lagged behind everything else. You are also insulated based on the structure against 30% credit enhancement.
Chris: Everyone is different, but I would say that over the last five years, we have seen a much greater acceptance of securitisation more broadly. The investor base has grown and there was a stigma around securitised after the GFC for years, and it slowly started to fade. Around 2019, it felt as though securitised credit in general was a defensive asset class, and then of course we had a global pandemic, and it was a little bit less defensive.
Over the past couple of years, because of lagging behind other asset classes, securitised is sticking out. If you are an insurance investor, and you are not as concerned with daily or weekly market-to-market volatility but are more buy-and-hold, then securitised makes a lot of sense.
Mike Hackmann: Yes, substantially. We have both a P&C and a life business, and, for both, if you look at the bonds that are running off and maturing not only this year but next year, the average book yield is low threes – so we are placing that double over the last year. It has been a huge lift to interest income in the portfolios, and, in fact, through the first 10 months of the year, our interest income was up 30% over the first months of last year too.
"I always say that Fanny and Freddy buy the stuff that
Silicon Valley bought in 2021."
What we are focusing on, especially now, is that it is obvious that the economy is going to slow down, as there is just not that much juice left. So, you want to prepare for some downturns or winter seasons. High-quality securitised assets in the portfolio are great and we have ramped up our securitisation allocation over the past five years to where it is significant – and the same with all the asset classes mentioned here too.
We feel that it makes a lot of sense within the portfolio and that you can generate a lot of yield. Especially on the agency mortgage side, I always say that Fanny and Freddy buy the stuff that Silicon Valley bought in 2021 – so, you are going to be in good shape because they are priced at their worst and extended at low dollar prices, so if interest rate rally, you are going to get paid off at par. The positive convexity of those securities is great.
"We stay focused on the ‘top of stack’ senior and
don’t get into the subordinated tranches."
Mike: We do that through a separately managed account, but, yes, all of the CLOs and business securitisation action is done in-house. We stay focused on the ‘top of stack’ senior and don’t get into the subordinated tranches. It is a private securitisation mandate.
Mike: As a smaller insurer, we use the insurance-rated note a lot on direct lending because we don’t have the size to do a separately managed account. To me, it is a huge disadvantage for smaller insurers that if you want to start attacking that structure you can’t because there isn’t the balance sheet to commit $400 million to a separate account. But the same assets are in there, so as long as the capital charges are relative it should be OK.
Some of the guidance we’ve recently received has pointed in that direction.
Asset managers are getting better at the separately managed account, and some of the issues that we have with these accounts are from a back-office standpoint – for example, pricing, the securities you get cash in, and where you then apply it. It has a small investment department and a small accounting staff – meaning one – so any time there are issues it goes all the way up.
If we can get it more streamlined, we’ll continue down that path. It is the accounting and back office that creates most of the issues.
